Bank lending and the housing market

Release date

28 January 2013

By Reserve Bank Deputy Governor Grant Spencer

As published in the New Zealand Herald and Dominion Post

Recent debate about rising house prices in Auckland and elsewhere has
included discussion on the risk weights the Reserve Bank requires banks to apply
to their housing lending. Some of this discussion has focused on the impact
that risk weights may have on the volume of credit, and house prices.

Risk weights play an important part in the Reserve Bank's supervision
of the banking sector. They help to determine the amount of capital that the
banks need to set aside to cover losses on their lending to different sectors.
In essence, the riskier the sector, the more capital must be held against
lending to that sector.

The risk weights factor in things like the borrower's capacity to repay
the money, the type of assets put up as security for the loan, and the amount of
security relative to the size of the loan. History provides some insight into
the importance of these various factors.

As a result of these risk factors, risk weights vary for different types of
lending, with housing having a lower risk weighting than business or rural
lending, which typically involve more risk.

The risk weights are not set in order to incentivise any particular lending
type over another. Instead, they reflect the different risks inherent in
different types of lending, leading to capital holdings against loans that are
appropriate for the risks involved. This tends to result in higher lending
margins on riskier loans, but does not imply that banks will always lend to
housing ahead of other sectors. In principle, banks will set loan margins such
that risk-adjusted returns will be similar across sectors.

The Reserve Bank sets its risk weights in accordance with the international
standards set by the Basel Committee on Banking Supervision, adjusted to fit the
New Zealand context. Indeed, risk weights on housing lending in New Zealand are
relatively high by international standards, the average in New Zealand being
almost three times that of the Canadian average or around 1.5 times that of
Australian or UK banks, according to a recent International Monetary Fund study.
So the NZ regime does not favour housing lending compared to international
norms.

The Basel Committee standards followed by the Reserve Bank provide for risk
weights to be adjusted in accord with local risk factors, such as the position
of the housing cycle. However, this facility is not designed to accommodate
economic or social objectives. Rather it is intended for overall financial
stability purposes – such as preventing an unusually large build-up of
lending risk in a particular sector.

A build-up of lending risk can, in some circumstances, leave banks
overexposed to a sector where an asset bubble develops and eventually bursts,
threatening the stability of the financial system overall. Adjusting risk
weights to account for these risks can help build greater resilience in the face
of such bubbles and, used early, could help prevent bubbles developing in the
first place.

Recently, regulators around the world have been developing macro-prudential
tools, which include the potential adjustment of sectoral risk weights. It is
one of a suite of macro-prudential tools the Reserve Bank has been assessing for
potential use in the future, including in situations where house prices may be
accelerating to unsustainable levels.

But adjusting sectoral risk weights in this manner is not for everyday use
and should be used under very specific conditions. It may be the case that an
alternative macro-prudential tool, such as Loan to Value Ratio (LVR)
restrictions, could be more appropriate in any given set of circumstances.

The framework the Reserve Bank is currently developing will establish the
parameters for using macro-prudential tools. This will include when and in what
conditions they might be appropriate, as well as clarifying governance and
accountability issues. A public consultation on macro-prudential policy is
expected to be released in late March.

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